Care About the Economy? Ignore the Goldman Sachs Testimony, and Watch the Fiscal Responsibility Commission Instead

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on Apr 28, 2010

While the Goldman Sachs testimony yesterday made all the political headlines yesterday, there was a second event occurring simultaneously that is much more important for our long-term economic security.  You see, despite all the rhetoric about financial regulatory reform, the Goldman Sachs hearings are really all about the past. 

The bigger story is about our future.  President Obama formally kicked-off of the “National Commission on Fiscal Responsibility.”

This Commission has the most difficult and important jobs in Washington – to figure out how to restore U.S. fiscal policy to something akin to a sustainable course.  It won’t be easy.  After 50+ years of total government spending comprising about 1/5 of the U.S. economy, the three entitlement programs – Medicare, Medicaid and Social Security – are projected – all by themselves – to exceed this share of the economy in the lifetime our today’s schoolchildren.  Throw in continued expenditures on all other functions of government – national defense, homeland security, environmental protection, education, the court system, and more – government spending is projected to consume an ever larger share of our economy.  This, in turn, has the potential to raise interest rates, crowd-out private investment, and thus reduce our rate of economic growth.

The President was careful not to take anything off the table yesterday.  That is important because this is not going to be an easy problem to solve.  At the end of the day, there are only two solutions to our fiscal problem. 

Solution 1: Raise more revenue.  In political terms, this means raising taxes.  I doubt that the Republican members of the Commission will be fond of this.

Solution 2: Cut spending.  In political terms, this means reducing the growth rate and/or level of benefits from “sacred cow” programs with vocal constituencies – such as seniors.  Democrats proved in 2005 that they are unwilling to cut benefits.  And many Republican members of the House sought to “solve” the problem through free lunch gimmickry, arguing that personal accounts (which I support, albeit for different reasons) would generate high enough returns that no benefit cuts would be needed. 

Where does that leave the Commission?  I see it most likely pursuing one of three possible outcomes.

Outcome 1:  The D’s and R’s on the Commission are unable to find enough common ground, and thus the Commission issues a final report that offers a series of options, each with proponents and dissenters.  In other words, partisanship.

Outcome 2: The Commission agrees they need to have at least some options that most members agree to.  And, caving to political pressure, they throw intellectual honesty out the window, and use a combination of both time-tested and brand new gimmicks to make it seem like the problem can be fixed without serious revenue increases or spending cuts.

Outcome 3:  The Commission takes a brave political stand by pointing out the extraordinarily difficult fiscal challenges ahead of us, proposes politically earth-shattering reforms, and then disbands and watches its proposals wither and die in the backrooms of Congressional committees.

Given the composition of the committee (see list here), I am optimistic that option 2 will be discarded.  But I think 1 and 3 are equally likely.

If there is hope for real reform coming out of this Commission, it will be because the Commission actually includes many sitting members of Congress who control the key committees.  In this important sense, this Commission has more in common with the 1983 Greenspan Commission, which led to politically difficult Social Security reforms being passed by Congress, than with the 2001 President’s Commission to Strengthen Social Security, which had no members of Congress and which saw its recommendations soundly ignored.

I hope my skepticism is mis-placed.  I sincerely hope this Commission comes up with good options, and that those in power listen.  If this happens, the long-term implications for “good” are far greater than 99% of all other economic news …

Adverse Selection — California Style

Filed Under (Health Care) by Nolan Miller on Feb 9, 2010

News from the West Coast today that Anthem Blue Cross, one of the largest private insurers in California, is raising the prices for the 800,000 or so people it sells individual health insurance policies by up to 39%.  The Obama administration is not happy, to say the least.  HHS Secretary Kathleen Sebelius fired off an angry letter to Anthem and its parent company, WellPoint, demanding an explanation.  Of course, this also comes at a time when the Obama administration is struggling to make the case that health insurance reform is urgently needed, so this also provides a perfect example for them.  The letter is kind of cool, since I have never seen an angry letter from a Cabinet Secretary before.  The text is here.

What I find more interesting as an economist, however, is WellPoint’s response.  They haven’t replied formally to the letter yet, but in a statement WellPoint’s spokesman said the following:

“As medical costs increase across our member population, premium increases to the entire membership pool result. Unfortunately, in the weak economy many people who do not have health conditions are foregoing buying insurance. This leaves fewer people, often with significantly greater medical needs, in the insured pool. We regret the impact this has on our members.”

So, where’s the economics lesson here?  In a competitive market, health insurance prices are driven by the cost of caring for the average person in the insurance pool.  That means that healthy people usually pay more than their actual cost of care and sick people pay less.  Although healthy people pay more than their average health expenditures in any year, they’re still willing to buy insurance because it provides them with, well, insurance.  In the event that they have a car accident or other unexpected, large expenditure on health care, they’re protected against the financial consequences.  This works fine as long as the premium (driven by the average cost of care) doesn’t get too high above what the healthy people are willing to pay for insurance against relatively rare events.

Now, enter the recession.  People are losing their jobs, wages for the employed are stagnating, and people are losing money on housing and financial investments.  In light of these challenges, some healthy people are looking at their health insurance premiums, their income, and the likely cost of going without insurance, and deciding not to buy health insurance.

This is a perfectly rational response to increasing premiums and decreasing incomes.  However, it results in the remaining people in the insurance people being, on average, sicker.  This means that the average cost of caring for the insurance pool will be higher, which will necessitate higher premiums.

Unfortunately (and interestingly if you study this stuff), this leads to the potential for what is known as an “adverse selection death spiral.”  The idea is that once premiums rise, the healthiest people who are still buying insurance may decide to drop out of the pool.  Since the remaining pool is even less healthy on average, premiums will once again need to rise to cover their higher medical needs.  And then the cycle starts over again.  In extreme cases, the premium just keeps going up until nobody is willing to buy insurance.

So, what next?  Well, the adverse selection story holds in competitive markets.  But, you can already see Secretary Sebelius telegraphing the administration’s punches.  They will argue that the price increases are not due to competitive pressure and an increasingly unhealthy insurance pool but rather a greedy, for-profit insurer trying to take advantage of people when they’re down.  For their part, WellPoint/Anthem will argue that this just shows why health reform is needed, but health reform of a fundamentally different sort than Obama has proposed.

My prediction is that we’re headed for a highly charged series of Congressional hearings that boil down to an attempt to drive home to voters that something needs to be done.  Really went out on a limb, there, didn’t I?

The 2011 Federal Budget: You Ain’t Seen Nothin’ Yet

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on Feb 2, 2010

Hollywood is abuzz today with the news of the 2010 Academy Award nominations.  If there were a category for “Most Frightening,” surely the newly released 2011 federal budget would be the odds-on favorite.  Released yesterday, the budget contains some difficult-to-swallow news about the difficult choices ahead of us.  

 Let me just highlight some of the more frightening numbers – all of which can be found in the proposed budget.  

  • Even with the President’s proposed tax increases and spending cuts, the projected single-year deficit never falls below $706 billion (that, in year 2014).  Indeed, it starts with a projected FY 2011 deficit of $1.566 trillion, and ends in 2020 with a $1 trillion deficit.
  • The debt held by the public is projected to roughly double over the next decade, from $9.3 trillion in 2010 to $18.57 trillion by 2020.
  • Of course, the economy is growing over this time (at least we all hope), so more meaningful numbers are relative to GDP.
    • The 2011 deficit is projected to be 8.3% of GDP
    • The debt held by the public will rise from 63.6% of GDP to 77.2% of GDP over the next decade.

 Of course, this may be a best-case scenario (in terms of deficits) because it assumes the President gets what he wants, including (as reported in today’s Wall Street Journal):

  • $175 billion rise in personal income taxes
  • $117 billion rise in corporate income taxes

 I’ve written previously about why deficits matter, primarily because they serve as a drag on long-term economic growth.  President Obama’s very talented budget director Peter Orszag understands this as well as anyone.

 But as bad as things look over the next few years, we need to recognize that the really long-term budget forecasts are far worse.  

 It is no secret that the biggest drivers of increased government spending over the long-run are the “Big Three” (meaning entitlements, not the auto-makers).  Growth in spending on Medicare, Medicaid and Social Security are projected to outpace overall economic growth for as far as the eye can see.  Unless these programs undergo structural change to rein in costs, the implications for our economy are enormous.

Consider this: for most of the last 50 years, government spending has stood around 20% of GDP (yes, it is higher now, but I am taking a longer-term view).  According to the Congressional Budget Office, by the year 2035 (about the time today’s newborn children are starting their own households, when today’s college graduates are in their middle ages, and when today’s middle-agers are set to retire), spending on Medicare, Medicaid and Social Security will be 16% of GDP all by themselves.  By 2080 (when today’s newborns are retiring), these programs will comprise nearly a quarter of GDP – a higher fraction than ALL government spending today.  So unless we change these programs, the rest of the government would need to cease operation, tax rates will have to skyrocket, or we are going to watch our debt grow to unprecedented levels relative to GDP.

 

The main drivers of these trends are rising per capita health care costs and population aging.  We have so far been woefully unsuccessful at dealing with the first, and we may not want to do anything about the second (after all, most of us like living longer).

 

In short, as bad as the short-term budget outlook is, the longer-term budget outlook is even worse. 

 

Sorry to be so pessimistic … but sometimes the facts speak for themselves.

“The Sunk Cost Fallacy” and President Obama’s Decision about the War in Afghanistan

Filed Under (Other Topics) by Jeffrey Brown on Dec 1, 2009

This evening, President Obama will make a prime-time address to the nation announcing his decision about whether or not to send more troops to Afghanistan.  This decision will fundamentally shape the future of that conflict, the world’s perception of our war on terrorism, the lives of those who live there as well as those who are sent to fight there, and, of course, our nation’s economic commitment.  

 

I do not pretend to be an expert on foreign policy in general or on Afghanistan in particular.  So I write this post today with no intention whatsoever of speculating about what course President Obama will choose or of critiquing whatever decision he does make.  I do, however, think it is worth making a simple observation about one possible rationale that is often used to justify a continued commitment to a conflict.  This is not a rationale that I have heard this President use – it will be interesting to see if he does so tonight – but it is one that has been uttered by many other elected officials.  The “rationale” is that we must continue fighting so that those who have given their lives in the war thus far “will not have died in vain.”

 

I, like the overwhelming majority of Americans, have tremendous respect, admiration and gratitude for all of the men and women who are willing to sacrifice so much to defend our nation.  These sacrifices are not limited to those who give their lives, but also include physical and psychological injuries, tremendous strain on families, and financial sacrifices, among many others.  As a nation, we should honor and provide assistance to all of those who have served in uniform as well as their families.

 

But do we need to continue fighting in order that those who died did not do so in vain? 

 

Believe it or not, the economics discipline provides a useful perspective on this issue.  (And it is a perspective that does not require that one think in terms of quantifying lives lost in dollar terms – an idea that economists often find useful, but that non-economists typically find extremely distasteful).

 

The idea from economics is known as the “sunk cost fallacy.”  One definition of this fallacy is “when we have a greater tendency to continue an endeavor once an investment in money, effort, or time has been made.”  More importantly, it is the tendency to do so even when the past investment of time, effort or money is completely irrecoverable.  This is fundamentally irrational, because if the costs cannot be recovered, then they should be irrelevant for making decisions about how to proceed.  Rather, future decisions should be based only on future benefits and costs. 

 

In the context of Afghanistan, the idea that “we must continue to fight so that those who died did not die in vain” is a manifestation of the sunk cost fallacy.  The rational counter-argument to this is that there is no decision that can be made on the future of Afghanistan that will bring our loved ones back.      

 

Those who bravely fought and died in Afghanistan did so in the service of their country, and nothing about President Obama’s decision this evening will change that.  To borrow Abraham Lincoln’s famous line in the Gettysburg Address, it is “far above our poor power to add or detract” from the honor that is due to those who died there.

 

So whatever decision is announced this evening, let us hope it is justified on the basis of whether it is the right decision for our nation going forward.  And let’s honor those who have died, rather than using their memory as a justification for supporting or criticizing whatever path we choose.